7.1 Costs That Matter for Decision Making: Opportunity Costs

accounting cost

The direct cost of operating a business, including costs for raw materials.

economic cost

The sum of a producer’s accounting and opportunity costs.

opportunity cost

The value of what a producer gives up by using an input.

Economists think about cost differently than many others do. Most people think about what we will call accounting costs, the direct costs of operating a business, including costs for raw materials, wages paid to workers, rent paid for office or retail space, and the like. Economic costs—the costs that economists pay attention to—include accounting cost and something else: the producer’s opportunity costs. Opportunity costs are what the producer gives up by using an input, whether that use is associated with an accounting cost or not. What the producer gives up is the return the input would earn in its next-best use: If a firm is using an input to do one thing, it is giving up the ability to use the input for something else. The lost value of this “something else” is the input’s opportunity cost.

To operate its flight schedule, for example, Ryanair keeps on hand an inventory of fuel. You might think that because Ryanair has already paid for the fuel, there is no longer any cost associated with it. But if we contemplate the fuel’s economic cost, then we quickly realize that it has an opportunity cost: Ryanair could sell the jet fuel to other companies instead of using it.

economic profit

A firm’s total revenue minus its economic cost.

accounting profit

A firm’s total revenue minus its accounting cost.

It is important to understand the distinction between economic cost and accounting cost because production decisions should be based on economic cost, not accounting cost. Ryanair should use its jet fuel for flights only if that is the most profitable use for it. That is, the firm should consider its economic profit (total revenue minus economic costs) rather than its accounting profit (total revenue minus accounting costs). If the price of fuel goes up enough, Ryanair should fly less and sell their fuel to make more money.

When thinking about the most cost-effective use of its inputs, it doesn’t matter if Ryanair’s accounting profit is positive. If its economic costs are large enough, its economic profit may be negative. In this case, it may make more sense for the firm to have fewer flights and sell its excess fuel to another company. Making decisions about the use of inputs using only accounting cost can lead to profit-losing practices.

The recognition that a firm’s decisions about production must be based on economic cost (which takes into account a firm’s opportunity costs) underlies everything we discuss about costs in the rest of this chapter and throughout the remaining chapters of this book. Unless otherwise stated, throughout this book when we talk about a firm’s costs, we are always talking about its economic costs (including opportunity costs).

Application: Making Big Money by Not Operating Your Business—A Lesson about Opportunity Cost

When electricity prices spiked in California in the summer of 2000, many businesses and homeowners winced as they saw their power bills rise to several multiples of their normal levels. However, one set of producers (besides the power generators) made out very well that summer: aluminum companies. Why? Because they decided to not make aluminum. This wasn’t because their customers didn’t want aluminum anymore. Instead, it was all about opportunity costs.

Aluminum smelting—the process through which metallic aluminum is extracted from ore—is done through electrolysis, which consumes massive amounts of electricity. Because of their need for a reliable supply of so much power, aluminum companies typically sign multiyear contracts with power generators that guarantee delivery of electricity at a price agreed upon in the contract.

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The key to understanding why aluminum companies benefited so much from sky-high electricity prices, and why they acted as they did, is to recognize that the prespecified prices in the aluminum companies’ electricity supply contracts did not reflect the companies’ true economic cost for electricity. By using that power to refine aluminum as they usually would, the firms would be giving up the ability to use that electricity for its next-best use. The value of this next-best use was the aluminum companies’ opportunity cost of its electricity, which in this case was the price at which the aluminum smelters could sell back that power to the electrical grid.

During the price spike of 2000, this sell-back price was very high compared to the delivery price in the smelters’ contracts. This meant that even though the contractual rate for the aluminum companies’ electricity purchases hadn’t changed, their economic costs of smelting aluminum, which included the opportunity cost of their electricity use, were extremely high.

They responded to the high economic costs by stopping their aluminum businesses and starting as electricity companies. The firm Kaiser Aluminum, for example, shut down its plant and took the power that it had earlier contracted to obtain for $22.50 per megawatt-hour (MWh) and sold back the power for $555 per MWh—or about 25 times what it paid! Kaiser made millions that year by not operating its plant. Kaiser’s employees benefited from this recognition of opportunity costs, too: Under pressure from unions and local and federal politicians, the company continued to pay its employees full wages while the plant was shut down—and it still made a profit.

figure it out 7.1

Cooke’s Catering is owned by Dan Cooke. For the past year, Cooke’s Catering had the following statement of revenues and costs:

Revenues $500,000
Supplies $150,000
Electricity and water $15,000
Employee salaries $50,000
Dan’s salary $60,000

Dan has always had the option of closing his catering business and renting out his building for $100,000 per year. In addition, Dan currently has job offers from another catering company (offering a salary of $45,000 per year) and a high-end restaurant (at a salary of $75,000 per year). Dan can only work one job at any time.

  1. What is Cooke’s Catering’s accounting cost?

  2. What is Cooke’s Catering’s economic cost?

  3. What is Cooke’s Catering’s economic profit?

Solution:

  1. Accounting cost is the direct cost of operating a business. This includes supplies, utilities, and salaries:

    Accounting cost = $150,000 + $15,000 + $50,000 + $60,000 = $275,000

  2. Economic cost includes both accounting cost and the opportunity costs of owner-supplied resources. Dan’s opportunity costs include the rent he could earn on his building ($100,000) and the opportunity cost of his time. Because Dan could give up the store and earn a higher salary at the restaurant, we need to take into account the difference in the salary he could earn ($75,000) and the salary he currently earns ($60,000). Note that his offer with the caterer is not relevant because opportunity cost measures the value of the next best alternative, which is working at the restaurant. Therefore, economic cost is Accounting cost + Opportunity costs:

    Economic cost = $275,000 + $100,000 + $15,000 = $390,000

  3. Economic profit is equal to Total revenue – Economic cost = $500,000 – $390,000 = $110,000. Dan should continue to operate his catering business.

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